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After a decade of tumultuous upheavals in the 1990s, the currency markets in the 21st century have been remarkably calm. They might not stay that way for long.
Lessons Learned
If the global currency markets are to avoid another crisis like those of the 1990s, they need to appreciate what caused the crises. Although opinions vary, the general consensus is that both the Mexican and the Asian crises were the result of formidable growth in the volume and speed of international capital movements with the persistence, in some countries, of a fixed exchange rate.
Economists maintain that a fixed exchange rate is difficult and costly to defend if there is an expectation that it will be depreciated in the future. The thinking is that if investors are sure a currency peg will eventually fail, they are more likely to launch a speculative attack sooner rather than later. Investor pessimism is often accompanied by a herd mentality, which results in investors abandoning a currency en masse. Economists believe this is why a currency crisis that starts in one country can easily spill over into neighboring countries.
The currency crises of the 1990s also highlighted the relative economic and fiscal immaturity that existed within some of these markets. As foreign capital flowed into a number of Asian economies in the 1990s, local banks became increasingly reliant on short-term foreign capital for financing domestic growth. As the currency devalued and investors fled the market, the banks could no longer rely on the foreign creditors to roll over existing short-term credit.
“The lesson especially learned by countries affected by the Asian crisis was to be careful about your short-term debt—not only as far as governments were concerned but also companies,” says Valentin Hofstätter, who heads RZB’s foreign exchange team. “A lot of these countries had short-term FX liabilities and were using fixed exchange rate regimes.” Banking and regulatory supervision in these markets was also immature, and hedging of FX risk was not widespread.
Dino Kos, executive vice president of the Federal Reserve Bank of New York, notes there has been a general shift away from fixed exchange rates in a number of the countries affected by the crises in the 1990s. In a speech to the Forex Network conference in New York earlier this year, he said: “Earlier regimes for these currencies all too often were overly rigid. Pressures would build, reserves would be exhausted, and massive volatility would follow.”
But, almost a decade on, has enough changed in these markets to avoid a repeat of 1997? Hofstätter believes so. A number of them now maintain floating currencies instead of fixed exchange rates pegged to the dollar, which he says discourages them from stockpiling short-term debt in the first place. “These countries now have huge current account surpluses so there is no need for external financing,” he adds.
In other developing markets, such as those in Central & Eastern Europe, for example, governments have historically run up substantial current account deficits and are still dependent on foreign capital flows. Hofstätter says that although the CEE countries have had huge capital inflows in recent years, in countries such as Slovenia and Poland, for example, this capital is earmarked for long-term investment projects. Additionally, these countries have floating exchange rates, and Hofstätter says they are more inclined to pay attention to currency risk now than perhaps they would have been a decade ago.
“The risk of another currency crisis [similar to those that occurred in the 1990s] happening is strongly diminished,” says Hofstätter. “If there is a crisis, it will be restricted to particular countries, which we have seen a little bit of in the last 12 months in Iceland, for example: Its currency depreciated by 30%, but the economy took it in its stride.” He cites Turkey as another example of a country that has weathered depreciations of its currency but not affected its neighbors in the process.
Brian Dolan, director of research at Forex.com, which is part of Gain Capital, believes increased sophistication on the part of central banks and finance ministries will avert another currency crisis. Unlike a decade or so ago, when Asian countries had minimal FX reserves, Dolan says that trend is now reversed. “Developing Asia is no longer developing,” he says. “They have substantial international currency reserves and increased sophistication in terms of market surveillance functions.”
Commenting on recent events such as the depreciation in Iceland, for example, Dolan distinguishes between a currency crisis and a currency adjustment. “That is the greatest risk out there we see at the moment,” he says. “Sharp adjustments of currency pairs—for example, the New Zealand and Australian dollar.” As the New Zealand dollar is an illiquid currency with high yields, if there was a serious development in the economic fundamentals or an official change in stance, the potential for a sharp fall in the New Zealand dollar is “very real,” he says.
The Wild West Element
While countries themselves have a fundamental role to play in shoring up their currencies through better and more transparent economic management and regulatory oversight, investors also play a role. They were responsible for the “contagion” that spread throughout Asia and Latin America like wildfire, bringing down currency after currency, regardless of the fundamentals.
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Dolan:Investors no longer view emerging markets as a single entity. |